Wednesday, May 23, 2012

“How to Weather the Storm”

Sydney M. Williams

Thought of the Day

“How to Weather the Storm”

May 23, 2012

Ironically, as portfolio management has increasingly become the purview of professional managers, the most fundamental reason for individuals to invest appears to have been forgotten. It is to produce a portfolio capable of generating a reasonably assured stream of rising income – to supplement government provided Social Security upon retirement. Instead, the market has become a casino, with high frequency traders accounting for 70% of total volume, and with a proliferation of a variety of derivative products ranging from indexes, to ETFs, to futures and options. Investment banks can create virtually any product to mimic any asset. Long term has become settlement date. Instead of attracting individuals into the market, such activities have driven them away.

After rising 26% between mid August and April 2, the S&P 500 declined 7.2% through yesterday. The market is lower than it was a dozen years ago. The flash crash of two years ago is vividly remembered by individuals. Bernie Madoff and MF Global have done nothing to improve confidence. Not one person responsible for the credit meltdown has gone to jail. Main Street has concluded that the game is rigged. Sentiment numbers show persistent concern. Interest rates are so low that cash is not a real alternative. Inflation simply erodes your assets more slowly. Morgan Stanley’s inept job of pricing and allocating last weeks’ Facebook offering, and NASDAQ’s mishandling of after market flow, only accentuated the lack of credibility in a legitimate and transparent market. What’s an investor to do?

Investing involves risk. It always has and always will. The extrapolation of recent events affects behavior. In 2000, most people were bullish. The crash of 1987 was long ago, and the market was sitting atop an eighteen-year bull market. Now, after more than a decade of poor performance the easiest path is to assume recent history will continue. Nevertheless, over time markets rise and fall, but mostly rise, reflecting the natural economic growth of the country.

Alternatives are limited. As stated above, cash makes little sense for those at or approaching retirement. For one concerned with preserving principal, there is no alternative to the Three-month Treasury Bill. A million dollars will generate $900 annually, substantially below the inflation rate and too little to feed one’s dog. In order to live, one would have to eat into capital. A million dollars in the Thirty-year bond would provide an annual income of $28,740.00. However, there is no chance that the yield would increase. Additionally, the investor assumes the risks of a rise in rates, which would cause a decline in one’s principal, and the erosion of the purchasing power of the dollar. An increase in rates to where they were ten years ago (which was a third of what they had been twenty years before that) would mean that the million dollars would be reduced to half a million dollars, and inflation would have reduced the value further. A holder would still receive his annual $28,740, and would have his million dollars returned in 2042, but with no assurance as to what the value of that million dollars would be.

Corporate bonds present some of the same problems as do Treasuries in that their price will decline should rates rise. Also, like Treasuries, the rate of interest will not increase, providing no protection against inflation. Unlike a Treasury, there is some risk that the bond could default. However, in the meantime the million dollars will produce somewhere between $40,000 and $77,500, depending on the quality of the bond purchased. Like Treasuries, though, the annual interest payment will not go up.

Commodities such as gold, silver or platinum may serve as protection against inflation, but provide no income, and can also incur a cost, for example for storage.

We are left with equities. Equities distinctly involve more risk than bonds. In the event of bankruptcy, they are last in line. Separating disinformation from accurate information is often difficult. When speaking with investors, company managements generally focus on opportunities, not risks. Brokers get paid by transactions, so despite regulations demanding they adhere to rules like suitability, incentives encourage them to generate trades.

Equities are also subject to all sorts of events including external pressures. The fear that Greece, with an economy that is roughly 2% of the U.S., might leave the Euro zone can cause American shareholders to lose sleep. When it is pointed out that Greece’s GDP is equivalent to less than two percent of U.S. equity values, the nay-sayers will talk about contagion. There is always something to worry about, and some of it we should. However, there is no way of predicting the future – good or bad. All we can say with any sort of certainty is that today’s prices will be different tomorrow. J.P. Morgan (the man, not the bank that now mocks his name), when once asked by a curious reporter what will happen to stock prices, responded, “They will fluctuate.” That they will.

Nevertheless, with all the problems we have, many of which I have described in earlier TOTDs, the U.S. still seems the safest place to invest. On a relative basis there are very few countries whose governments are more open than ours and whose legal system is as fair. We may be on a downward sloping path, but we remain the preferred venue.

Good, dividend paying companies seem an obvious strategy. Within the S&P 500 companies, there are eighty-eight that pay a dividend yield ranging from 2.5% (Microsoft) to 3.5% (Kellogg.) Among those eighty-eight companies, one should be able to create a decent portfolio whose payout ratio allows some ability for growth. While such a portfolio would not protect an investor against the vagaries of the market over the short term, the portfolio’s income should be reasonably protected. Obviously such a portfolio would have to be monitored for conditions that could cause a dividend to be cut, or against the possibility that a stock might rise to such a premium that the (current) yield would no longer be attractive to a buyer.

Dividends have risen during most years. Between 1960 through 2011, average annual dividend growth for the S&P 500 was 5.4%. That could be compared to an average annual increase in inflation over that same period of time of 4.1%.

Protecting capital is the preferred strategy in times of uncertainty. Protecting income, while preserving the opportunity for upside in income, would seem to be the more attractive strategy in today’s world for those looking toward retirement. It is estimated that 10,000 people per day for the next sixteen years will reach 65. What makes the strategy of simply protecting capital so unattractive in today’s environment is the fact that the only way to do so is through Treasury Bills that pay only a nominal rate. No other asset class is assured of protecting one’s principal. A twenty-year bond will return your investment when it matures in twenty years, but in the interval the bond will trade based on the direction of interest rates and according to its perceived credit risk. Additionally, should inflation in the next twenty years approximate the last fifty years, the million dollars would be worth about $400,000 in today’s dollars in twenty years. No one can accurately predict the volatility in commodities, bonds or stocks.

While nothing is ever assured, it is easier to forecast the general direction of a company’s earnings than the price that company’s stock might sell for over the next six months.

My conclusion: The best port in this storm for the uncertainty we face will likely continue to be a focus on preserving one’s income by buying high quality dividend paying companies where the opportunity for increases exists. Assets will fluctuate; so look for stability in income.